With lower investment asset valuations, historically low interest rates, and a temporary increase in the estate and gift tax threshold, 2020 is a good year to review and update your estate plan and gifting strategies.
Now is the optimal time to review your gifting strategy
Opportunities are possible even in downturns. With the recent market and stimulus package changes, now is an optimal time to review your estate plan. A perfect trifecta—lower investment asset valuations, historically low interest rates, and a temporary increase in the estate and gift tax threshold—have converged to provide an opportunity that allows you to maximize your gifting.
- Lower asset valuations: While lower investment account values are not ideal, this does create an opportunity for wealth transfer, as you can pass on your assets at a lower value and allow your assets to grow outside your estate. This is a key wealth-shifting opportunity since lower assets usually translate to lower applicable taxes.
- Historically low interest rates: The interest rates used in estate planning are at historically low rates. For example, the interest rate on private loans between related parties, like family members, (called the mid-term interest rate) is only 0.58% for loans lasting 3-9 years, while rates for long-term loans are only 1.15% for loans lasting 9+ years. This low-interest-rate environment creates an opportunity to use wealth-transfer tools that benefit from low rates, such as intentionally defective grantor trusts (IDGTs) and grantor retained annuity trusts (GRATs).
- Temporary increase in the estate and gift tax threshold: The gift and estate tax exemption for 2020 is $11.58 million per person. For married couples, it’s over $23 million that they can give to their loved ones and other beneficiaries. But the gift and estate tax exemption is set to expire at the end of 2025, (the current law states this exemption may be cut in half to what will likely be less than $6 million) and many in Congress would like to reduce this amount even further, with proposals to reduce the exemption amount to $3.5 million.
Using an IDGT to transfer wealth
So, if now is the right time to take advantage of the three timely events outlined above, how do you gift your assets appropriately? Perhaps you don’t want to give a large sum of money directly to your children and you worry about possible life events such as divorce, bankruptcy, or a bad business deal impacting where and how your gift is spent.
An intentionally defective grantor trust (IDGT) provides valuable protection, as well as income, gift, and estate tax benefits. With an IDGT, you create an irrevocable trust for the benefit of your loved ones or beneficiaries. Generally, an IDGT allows the trustee to make annual discretionary distributions, or standard income distributions, to your beneficiaries. Placing your assets in this type of a trust allows your loved ones to benefit from the assets without giving them outright access.
An IDGT also offers an income tax benefit by allowing the trust assets to grow tax free. Although you’re responsible for paying the income tax on your assets going into the trust, the assets are removed from your estate for gift and estate tax purposes. As a result, the trust grows tax free, and all that growth takes place outside your estate.
How an IDGT reduces your taxes
You can fund an IDGT by selling assets to the IDGT in exchange for a promissory note. You will then have a note that will be paid back over time, with the IDGT holding the assets. This is referred to as an “estate freeze technique” because it transfers an asset out of your estate at today’s value (sometimes less than fair market value) without using any of your gift and estate tax exemption. All future growth of the assets occurs in the trust, which is outside of your estate. For example, if the assets sold to the IDGT produce a total return (income and appreciation) in excess of the interest rate on the promissory note, substantial wealth can be removed from your gross estate—both gift and estate. Based on today’s interest rates, that annual growth would only need to be between 0.58%-1.15%, depending on the loan terms.
Let’s take, for example, a mother who wants to gift her three children $6 million in company stock but wants to make sure they don’t receive the entire amount all at once. The company is growing rapidly and is expected to exceed future estate taxes if the stock remains in her estate. Her estate lawyer sets up the IDGT and creates the promissory note. The IDGT is funded with the stock, and in exchange, the IDGT gives the mother back a note in the amount of $6 million, payable over 20 years. She retains her entire estate tax exemption amount, which is $11.58 million in 2020, because this transfer is not a gift due to the use of the note that will be paid off by the IDGT over 20 years.
Due to the way the IDGT is structured, there are no taxes on this transaction, not even capital gains, because the stock is still considered owned by the mother for income tax purposes. The business pays dividends, which is enough to cover the note payments which are much lower than a commercial note, at only 1.15%. When the mother dies, her brother, the trustee, doles out income to the beneficiaries. Of course, the growth of the $6 million dollars, which has now turned to $25 million over 20 years, passes free of estate tax because it is outside the mother’s estate when she dies. This is important because this allows the mother’s estate to remain below the estate tax exemption amount, thereby avoiding estate tax altogether.
Taking advantage of today’s ideal gifting environment
An IDGT is just one of many options that can be used to take advantage of today’s ideal gifting environment. If you’re able to gift and would like to take advantage of this opportune time, contact your advisor to discuss your options. Utilizing various gifting strategies can help you both transfer your wealth and protect it for generations to come.
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